How ESOPs Work: Is an ESOP a Good Fit For Your Construction Company?

by: Smith and Howard

March 25, 2015

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With many contractors reaching retirement age over the next 10 years, succession planning is understandably top of mind for many of them. One approach to succession planning that has received quite a bit of attention for some time is the employee stock ownership plan (ESOP). But do ESOPs fit the distinctive aspects and challenges of a construction business? It’s a question worth asking.

Considering the concept of an ESOP

An ESOP is a type of employee benefit plan, similar in many ways to a profit-sharing plan. To set up an ESOP, a company establishes a trust fund and contributes either new shares of its own stock or money to buy existing shares. The shares in the trust are then allocated to individual employee accounts, based on compensation, and the employees become vested in the accounts over a specified period of service years.

One reason for companies to establish an ESOP is to buy the shares of an owner who wants to retire. In many closely held or family-owned businesses, including construction companies, there isn’t a family or staff member who’s capable of or interested in taking over when the founder is ready to leave. In such cases, the company can make tax-deductible contributions to an ESOP to buy the owner’s shares or have the ESOP borrow money to buy shares. Either way, the company enjoys tax advantages while helping to deal with the succession issue.

A retiring owner also can cash out over time, keeping a seat on the ESOP trustee board and, thus, retaining voting rights in management decisions during the transition. In this manner, businesses with an ESOP are often better able to keep valuable and experienced staff on board through management changes. In addition, an ESOP can serve to motivate staff to work harder toward the company’s success — because they’re part owners.

Reaping tax advantages of ESOPs

The tax advantages of ESOPs are considerable. All contributions to the plan are tax-deductible, including shares of stock, cash contributions (whether they’re used to buy stock or to build up a cash reserve) and any payments made to repay loans taken out by the ESOP.

In addition, in C corporations, sellers are eligible for a tax deferral. Once the ESOP owns at least 30% of the company’s shares, the seller can reinvest sales proceeds in other securities and defer taxes on the gains as long as the rollover is executed within a specified time.

In S corporations, the percentage of ownership held by an ESOP is tax-exempt at the federal and usually at the state level as well. When an ESOP holds 30% of an S corporation’s stock, 30% of profits are tax-exempt. When the ESOP holds all of the S corporation’s stock, there’s no income tax owed on any of the company’s profits.

Last, ESOPs are allowed to borrow. When the plan does so to buy new or existing shares, the company can then make tax-deductible contributions to the ESOP in repayment. In such a case, both principal and interest are deductible.

Assessing the downsides of ESOPs

ESOPs incur considerable startup and maintenance costs that can run into tens of thousands of dollars, even for small businesses. Midsize to larger companies may face even higher expenses based on the complexity of the arrangement.

A greater potential risk is the pool of money needed to buy back shares of departing employees — at an independently established fair market value.

So the company or ESOP must maintain enough liquid assets to repurchase the shares of employees who leave. If the stock price appreciates substantially, doing so can be a tall order for contractors, who commonly face cash-flow dilemmas associated with the unpredictable nature of construction projects and backlog.

An ESOP can also substantially affect your bonding capacity. So be sure to consider these risks with your surety representative before creating an ESOP.

ESOPs and surety bonds

Contractors — particularly those that bid on public projects — rely on their ability to secure surety bonds, which guarantee to a project owner that the company will perform its work in compliance with the contract terms. As you know, surety brokers evaluate your company carefully before issuing bonds to ensure you’re well managed, generally able to meet your obligations and, preferably, profitable.

On the plus side, a well-designed ESOP can show that a contractor has a continuity plan in place and cares about retaining key employees. By reducing the company’s corporate income tax burden, an ESOP may also boost cash flow and net worth, which can help with bonding capacity, too.

On the down side, should you need to borrow money to meet the ESOP’s financial obligations, that loan will be recorded as a liability on your balance sheet. In turn, your net worth will be negatively affected and your bonding capacity quite possibly will be impacted.

Discussing the implications of an ESOP

Make no mistake — establishing an ESOP is a major undertaking for any construction company. So be sure to discuss the implications beforehand with your financial advisor, legal counsel and, as mentioned, bonding provider.

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